Chapter 05 – Understanding Risk
Multiple Choice Questions
1. Which of the following would not be included in a definition of risk?
D. Risk usually involves some future payoff
2. All other factors held constant, an investment:
A. With more risk should offer a lower return and sell for a higher price
3. Uncertainties that are not quantifiable:
A. Are what we define as risk
Chapter 05 – Understanding Risk
4. When measuring the risk of an asset:
D. One cannot use other investments to evaluate the asset’s risk
5. Which of the following is true?
D. Risk-free investments are the best benchmark for measuring the risk of all investment
strategies
6. Inflation presents risk because:
A. Inflation is always present
Chapter 05 – Understanding Risk
7. If the probability of an outcome equals one, the outcome:
D. Has unquantifiable risk
8. If a fair coin is tossed, the probability of coming up with a head or a tail is:
A. ½ or 50 percent
9. If the probability of an outcome is zero, you know:
A. The outcome is more likely to occur
Chapter 05 – Understanding Risk
10. The expected value of an investment:
A. Is what the owner will receive when the investment is sold
11. If an investment will return $1,500 half of the time and $700 half of the time, the expected
value of the investment is:
A. $1,250
12. Another name for the expected value of an investment would be:
D. The risk-free value
Chapter 05 – Understanding Risk
13. If an investment has a 20% (0.20) probability of returning $1,000; a 30% (0.30)
probability of returning $1,500; and a 50% (0.50) probability of returning $1,800; the
expected value of the investment is:
D. $1,600.00
14. Suppose that Fly-By-Night Airlines, Inc. has a return of 5% twenty percent of the time
and 0% the rest of the time. The expected return from Fly-By-Night is:
A. 10%
15. An investor puts $1,000 into an investment that will return $1,250 one-half of the time and
$900 the remainder of the time. The expected return for this investor is:
Chapter 05 – Understanding Risk
16. An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the time;
$2,000 one-half of the time, and $1,750 the rest of the time. What is the investor’s expected
return?
A. 12.5%
17. If an individual voluntarily purchases insurance on his/her home to protect against a loss
due to fire, the individual:
D. Has underestimated the probability that a fire will occur
18. Risk-free investments have rates of return:
D. That exhibit a large spread of potential payoffs
Chapter 05 – Understanding Risk
D. Both a low expected return and a low value at risk
20. An investment pays $1,500 half of the time and $500 half of the time. Its expected value
and variance respectively are:
A. $1,000; 500,000 dollars
21. An investment pays $1,200 a quarter of the time; $1,000 half of the time; and $800 a
quarter of the time. Its expected value and variance respectively are:
D. $1,000; 80,000 dollars
Chapter 05 – Understanding Risk
22. An investment pays $1000 three quarters of the time, and $0 the remaining time. Its
expected value and variance respectively are:
A. $1,000: 62,500 dollars
23. The standard deviation is generally more useful than the variance because:
A. It is easier to calculate
24. Given a choice between two investments with the same expected payoff:
D. Most people will calculate the variance to assess the relative risks of the two choices
Chapter 05 – Understanding Risk
25. An investment will pay $2,000 half of the time and $1,400 half of the time. The standard
deviation for this investment is:
D. $30
26. An investment will pay $2000 a quarter of the time; $1,600 half of the time; and $1,400 a
quarter of the time. The standard deviation of this asset is:
A. $600
27. Which of the following statements is correct?
Chapter 05 – Understanding Risk
28. Which of the following statements is correct?
A. Investment A and B have the same expected value, but A has greater risk
29. The greater the standard deviation of an investment:
D. The greater the return
30. The difference between standard deviation and value at risk is:
A. Nothing, they are two names for the same thing
Chapter 05 – Understanding Risk
31. A $600 investment has the following payoff frequency: a quarter of the time it will be $0;
three quarters of the time it will pay off $1000. Its standard deviation and value at risk
respectively are:
D. $433; $1000
32. A $500 investment has the following payoff frequency: half of the time it will pay $350
and the other half of the time it will pay $900. Its standard deviation and value at risk
respectively are:
D. $125; $500
33. The measure of risk that focuses on the worst possible outcome is called:
34. Leverage:
35. Which of the following individuals is least likely to use value at risk as an important
factor in his/her investment decision?
A. An individual considering a mortgage to buy his first home
36. Comparing a lottery where a $1 ticket purchases a chance to win $1 million with another
lottery in which a $5,000 ticket purchases a chance to win $5 billion, we notice many people
would participate in the first but not the second, even though the odds of winning both
lotteries are the same. We can perhaps best explain this outcome by:
Chapter 05 – Understanding Risk
37. Which of the following statements is true?
D. Leverage lowers the expected return and increases risk
38. Which of the following statements is true?
D. Leverage decreases expected return and increases risk
39. Which of the following investment strategies involves generating a higher expected rate of
return through increasing risk?
A. Diversifying
Chapter 05 – Understanding Risk
40. A risk-averse investor versus a risk-neutral investor:
D. Needs less compensation for the same risk versus the risk neutral investor
41. A risk-averse investor will:
A. Always accept a greater risk with a greater expected return
42. A risk-averse investor will:
D. Always focus exclusively on the expected return
Chapter 05 – Understanding Risk
43. Up to what amount would a risk-neutral gambler pay to enter a game where on the flip of
a fair coin, if you call the correct outcome the payoff is $2000?
A. More than $1000 but less than $2000
44. Professional gamblers know that the odds are always in favor of the house (casinos). The
fact that they gamble says they are:
A. Irrational
45. The most a risk-averse individual would pay to participate in a flip of a fair coin with a
payoff of $500 if the correct outcome is called is:
D. An amount not to exceed $500
Chapter 05 – Understanding Risk
46. The risk premium for an investment:
A. Is negative for U.S. Treasury Securities
47. A risk-averse investor compared to a risk-neutral investor would:
D. Place less focus on expected return than the risk-neutral investor
48. When considering different investments, a risk-averse investor is most likely to focus on
purchasing:
D. Investments with the lowest risk premium, regardless of the expected rate of return
Chapter 05 – Understanding Risk
49. Uncertainty associated with the expected rate of return on an individual stock reflects all
of the following except:
A. Idiosyncratic risk
50. We observe an increase in the price for Apple stock, while other Nasdaq-listed companies
experience no change in their share prices. The increase in Apple’s stock price most likely
reflects (with respect to Apple):
A. An increase in systematic risk
51. Which of the following statements is most correct?
D. Usually expected returns are not associated with risk premiums
Chapter 05 – Understanding Risk
52. The fact that over the long run the return on common stocks has been higher than that on
long-term U.S. Treasury bonds is partially explained by the fact that:
A. A lot more money is invested in common stocks than U.S. Treasury bonds
53. Idiosyncratic risk:
D. Impacts all firms in the same industry equally
54. When the home construction industry does poorly due to a recession, this is an example
of:
D. Unique risk
Chapter 05 – Understanding Risk
55. Unique risk is another name for:
A. Market risk
56. High oil prices tend to harm the auto industry and benefit oil companies; therefore, high
oil prices are an example of:
D. Both systematic and idiosyncratic risk
57. Changes in general economic conditions usually produce:
D. Lower risk premiums
Chapter 05 – Understanding Risk
58. Unexpected inflation can benefit some people/firms and harm others. This is an example
of:
A. Systematic risk
59. Diversification is the principle of:
A. Eliminating risk
60. Diversification can eliminate:
A. All risk in a portfolio